- The Washington Times - Tuesday, May 16, 2006

If last week’s 2.6 percent drop in the Standard & Poor’s 500 Index seemed somehow familiar, it was.

Like a rite of spring, the stock market has undergone corrections in each of the past three years. Yet, while 2004 and 2005 ended on a high note for stocks, there’s reason to believe that this year’s spring dip could be more pronounced — and harder to overcome.

“It wouldn’t be at all surprising for the market to undergo a correction after the kind of six-month advance we’ve seen,” said Ken Tower, chief market strategist for Schwab’s CyberTrader. “We’ve seen that for a few years now, having this kind of correction heading into the summer.”

In 2004, the S&P; dropped 5.71 percent from April 5 to May 17. Yet from May 17 through the end of the year, the index gained 11.79 percent.

Likewise, in 2005, the S&P; fell 7.17 percent from March 7 through April 20, then gained 9.74 percent from April 20 to Dec. 30.

Investors hoping for a repeat in 2006 could point to a handful of similarities with the past three years. The economy still grew at a strong rate through the first quarter of this year, and corporate America has posted double-digit profit increases once again — the 16th consecutive quarter for such gains.

In addition, while oil prices are climbing now, that only continues a trend from the past two years. The same goes for interest rates — the Federal Reserve has been raising them since June 2004.

“If you look at it that way, then it seems that nothing has really changed,” said Bob Doll, president and chief investment officer of Merrill Lynch Investment Management.

But, Mr. Doll said, “those are the constants. You’re seeing some things different this year on top of that.”

For one, crude oil prices are now hovering around $70 per barrel, and aren’t expected to decline much, if at all, through the rest of the year. And two years of interest rate increases are starting to work their way through the economy, making credit more expensive for consumers and businesses alike.

Higher mortgage rates are expected to continue pressuring the housing market, which has plateaued this year — raising the question of whether the housing bubble will burst, or gently deflate. Nobody is expecting it to expand.

All that translates into a cooling economy, with real estate softening, consumers reining in their spending and corporate profit margins shrinking. That means slower earnings growth, which makes stocks in turn seem riskier.

With that scenario expected to take hold in the second half of the year, investors could be hard pressed to pile back into stocks right away — especially with Treasury bills and even certificates of deposit paying 5 percent.

“I can very much see major investors, especially the large brokerage houses, asking themselves why they’d risk money on stocks when they have those guaranteed returns elsewhere,” Mr. Tower said.

Additionally, investors have shied away from the technology sector in the past few months, instead favoring what Mr. Doll calls “smokestack America” — energy, manufacturing and materials stocks. So while the Nasdaq helped shore up the markets in 2004 and 2005, analysts think it would have to catch up to the other major indexes if the market is to rally strongly in the second half of the year. With the technology sector seeing weaker sales and slipping profit growth, that’s unlikely.

“If you put all these things together — the high commodity prices and interest rates, the Nasdaq, the transition to small- to larger-cap stocks — maybe there’s some transitioning happening here,” Mr. Doll said.

The nature of that transition, and whether it will lead to yet another year-end rally, depends on how deep the changes go, Mr. Doll said. If the economy slows modestly and corporate profits remain strong, then stocks may yet finish the year with small gains.

“But if it’s a more significant slowdown in the economy and earnings than we thought, this decline could last longer and be more difficult than we expect,” Mr. Doll said. “The thing is, I don’t think we can go substantially higher right now. The debate is between more sideways sloppiness or even more of a correction.”

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